The Inflation Warning Signs Are Piling Up

Jeff
Kleintop Analyzes and discusses international
markets, trends and events to help U.S. investors
understand their significance and financial implications.
In this role, Kleintop provides research, commentary and
actionable insights to Schwab’s client-facing teams and
the firm’s Investor Services and Advisor Services clients
through written reports, video content, conference calls,
webcasts and in-person events.

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The Big Bang Theory, the most watched television comedy, is about
a group of physicists and their aspiring actress friend from
across the hall. The show often refers to theoretical physicist
Sheldon Cooper’s quest for a Nobel Prize in physics as he
frequently derides the work of his experimental physicist
roommate, Leonard Hofstadter, and puzzles his neighbor, Penny.
Life imitates art: recent data suggests MIT theoretical physicist
Alan Guth (think Sheldon) is likely to be awarded the Nobel Prize
for his inflation theory of the origin of the universe now that
an experiment by astrophysicist John Kovac (think Leonard) found
evidence of the origin of the big bang in a ripple pattern of
rapid acceleration outward in polarized cosmic radiation (think
Penny giving a confused look).

It does not take a Ph.D. to see that we may be witnessing a big
bang in inflation. The popular theory that accelerating price
inflation in the U.S. would eventually be detected has gone many
years with little evidence. However, signs that inflation has
probably bottomed are now showing up everywhere.

The Consumer Price Index, the most commonly cited and used
measure of inflation, averaged 1.4% over the past year, but
rebounded from 1.1% in February to 1.5% in March.

The Producer Price Index, a measure of what companies are
paying for inputs, increased 0.5% in March and was up even more
excluding food and energy (0.6%), accelerating 1.5% year over
year.

A number of the companies that have reported first quarter
earnings discussed improving pricing for their products and
services. In fact, the co-CEO of a fast food chain said during
the company’s earnings call, “We believe we’ve got a lot of
pricing power. We feel very comfortable that if we raise prices
somewhere in that mid-single digit range, we still got room.”

 After sliding for three years, commodity prices, measured
by the Commodity Research Bureau Commodity Index, appear to have
started to rebound [Figure 1]. Food prices are rising in part due
to the extended effects of severe weather. And fuel prices have
been rising — with gasoline prices at the pump jumping 45 cents
over the past five months to a national average of $3.65 per
gallon.

Average hourly earnings for American workers appear to
finally be running consistently above a 2% annual growth rate.

LPL Financial

Now that evidence has emerged that inflation has bottomed, the
question is how much prices inflate. All of that quantitative
easing (QE), or Federal Reserve (Fed) bond buying from the banks,
is potential “energy” to fuel inflation. While thus far it has
largely remained in the form of reserves on bank balance sheets,
bank lending is finally beginning to reaccelerate—a necessary
driver for growth in the money supply.

This is an intended outcome for the Fed. The Fed is focused on
lifting inflation and sees it as important for achieving
sustainable growth. Last week Fed Chair Yellen said: “A
persistent bout of very low inflation carries other risks as
well. With the federal funds rate currently near its lower limit,
lower inflation translates into a higher real value for the
federal funds rate, limiting the capacity of monetary policy to
support the economy. Further, with longer-term inflation
expectations anchored near two percent in recent years,
persistent inflation well below this expected value increases the
real burden of debt for households and firms, which may put a
drag on economic activity.” Or, as Sheldon might put it: Bazinga!

LPL
Financial

The early stages of accelerating inflation have historically
helped fuel economic growth as consumers begin to expect price
increases and may stop delaying purchases. The early stages of
inflation picking up have also been good for stocks. Examining
periods since 1950, the valuation of the stock market measured by
the S&P 500 trailing price-to-earnings ratio (PE) tends to be
higher when the Consumer Price Index rises above the current 1.5%
[Figure 2]. In fact, S&P 500 PEs tend to be a whole point
higher than the current 16.8 when inflation is between 1.5 and
2.5%, a range some signs are pointing for the coming year. Only
as inflation rises above 3.5% has it corresponded with lower PEs.